macroeconomics ii macroeconomics 2 -...

Dynamic approach to short run economic

fluctuations.

Part 1.

The Phillips Curve & Dynamic Aggregate Supply.

Macroeconomics II

Macroeconomics 2

Dr hab. Joanna Siwińska-Gorzelak

WNE UW

Motivation

• The static AD/SAS model fails to take into account

inflation

• The dynamic model, which we will start to discuss today,

allows to model inflation and dynamic interactions

between consecutive periods

• Today we will develop the dynamic aggregate supply line

(DAS) - the supply side of the DAD/DAS model and the

famous and very closely related Phillips curve

• While later on we will focus only on DAS, it is good to

know the Phillips curve as well

Important

• If you have difficulties with the AD/AS model, please read

chapters 10, 11 and 13 from Mankiw!

Recall the aggregate supply curve (SRAS)

Three broad explanations are offered:

1. The sticky-wage model

2. The imperfect-information model

3. The sticky-price model

All three imply a relationship that can be approximated by a simple formula (but note that the equation can also be more complicated – for example the function can be non-linear :

natural rate

of output

a positive

parameter

the expected

price level

the actual

price level

agg.

output

)( e

ttttPPYY

Recall the aggregate supply curve (SRAS)

Each of the

three models of

agg. supply imply

the relationship

approximated by

the SRAS curve

& the simple

equation. Y

P LRAS

Y

SRAS eP P

eP P

eP P

)( e

ttttPPYY

Deriving the Dynamic Aggregate Supply & the Phillips

curve from aggregate supply

The DAS Curve -

we will use it later!

)()1( e

ttttPPYY

))(/1()2(tt

e

ttYYPP

ttt

e

ttYYPP ))(/1()3(

)ln(]))(/1ln[()ln()ln()4(11 tttt

e

tttYYPPPP

tt

e

ttyy )()5(

We can also use

a more

complicated

equation

Substract Pt-1 from both sides and take logs.

Deriving the Dynamic Aggregate Supply & the

Phillips curve from aggregate supply

tt

e

ttyy )()5(

)()()6(Nttt

uuyy

tNt

e

ttuu )()7(

Okun’s Law

Phillips curve

Okun’s Law

Source: ECB, 2011

The DAS curve and the Phillips Curve – the first

building block of the DAD/DAS model

The DAS curve states that current is related to:

• expected inflation, e.

• Deviations of output from the natural rate

• supply shocks,

The Phillips curve states that current is related to

• expected inflation, e.

• cyclical unemployment: the deviation of the actual rate of

unemployment from the natural rate

• supply shocks,

Intuition of the DAS & Phillips curve: an ongoing, anticipated inflation

in the AS/AD model

Intuition of the DAS & Phillips curve: Unanticipated inflation

in the AD/AS model

The Phillips Curve and SRAS

• DAS curve: Deviations of output from its natural

level are related to unexpected movements in the

inflation rate.

• Phillips curve: Deviations of unemployment from its

natural rate are related to unexpected movements in

the inflation rate.

The second building block of the DAS: adaptive

expectations

• Adaptive expectations: an approach that assumes

people form their expectations of future inflation

based on recently observed inflation.

• A simple example:

Expected inflation = last year’s actual inflation

Then, the DAS becomes

11 tttE

ttttyy

)(

1

The Dynamic Aggregate Supply Curve

DAS slopes upward:

high levels of output are

associated with higher-

than-expected inflation.

This is because of

demand-pull inflation

Yt

πt

DASt

ty

tt

1

ttttyy

)(

1


A change in

previous period’s

inflation shifts the

DAS curve

Yt

π

DASt=1

Y

0t

ttttt

yy 1

0t

Assume

DASt=2

1t

10


An change of the

natural level of output

will shift the DAS curve

Yt

π

DASt=1

1tY

10

tt

0

DASt=2

Assume that

2tY

ttttt

yy 1


A supply shock will

shift the DAS curve

Yt

π

DASt=1

tY

0t

0210

tttand

DASt=2

21

tt

Assume that

ttttt

yy 1

Inflation expectations

• We are assuming a very simple way of expectation

formation; the reality can be much more complex.

• For example, recently some researches talk about

„anchored expectations”, with very interesting implications

for the Phillips Curve

Inflation inertia

In this form, the DAS (and Phillips curve) implies

that inflation has inertia:

• In the absence of supply shocks or deviations of output (and

unemployment) from its natural level, inflation will continue

indefinitely at its current rate.

• Past inflation influences expectations of current inflation, which

in turn influences the wages & prices that people set and

actual inflation.

ttttyy

)(

1

Two causes of rising & falling inflation

• cost-push inflation:

inflation resulting from supply shocks

Adverse supply shocks typically raise production

costs and induce firms to raise prices,

“pushing” inflation up.

• demand-pull inflation:

inflation resulting from demand shocks

Positive shocks to aggregate demand cause

unemployment to fall below its natural rate,

which “pulls” the inflation rate up.

ttttyy

)(

1

The Phillips curve

People adjust their

expectations over

time,

so the tradeoff only

holds in the short run.

u

nu

1

e

2

e

E.g., an increase

in e shifts the short-run P.C.

upward.

In the short

run, policymakers face a

tradeoff between and u.

The sacrifice ratio

• To reduce inflation, policymakers can contract agg.

demand, causing unemployment to rise above the natural

rate.

• The sacrifice ratio measures the percentage of a year’s

real GDP that had to be foregone to reduce inflation

by 1 percentage point.

• Sacrifice ratio = (lost GDP)/(total disinflation)

The natural rate hypothesis

Changes in aggregate demand affect output

and employment only in the short run.

In the long run, the economy returns to

the natural levels of output, employment,

and unemployment

An alternative hypothesis: Hysteresis

• Hysteresis: the long-lasting influence of history on

variables such as the natural rate of unemployment.

• Negative shocks may increase un, so economy may not

fully recover.

Hysteresis: Why negative shocks may increase

the natural rate

• The skills of cyclically unemployed workers may

deteriorate while unemployed, and they may not

find a job when the recession ends.

• Cyclically unemployed workers may lose

their influence on wage-setting;

then, insiders (employed workers)

may bargain for higher wages for themselves.

Result: The cyclically unemployed “outsiders”

may become structurally unemployed when the

recession ends.

„Old-fashioned Phillips curve” ?

• Krugman writes: „For one thing, the “accelerationist”

doctrine that has dominated economic discussion of

inflation and unemployment for 40 years has fallen flat.”

• “Anchored” expectations. Price- and wage-setters now act

as if they expect policymakers to hit their target (say: 2%)

• „Operationally, of course, such a curve looks just like the

old, pre-NAIRU Phillips curves people estimated in the

1960s.”

During the recent crisis…

• “The surprise [about inflation] is that it’s fallen so little,

given the depth and duration of the recent downturn.

Based on the experience of past severe recessions, I

would have expected inflation to fall by twice as much as

it has.” (John Williams, 2010.)

The changing Phillips curve

Source: Paul Krugman,

https://krugman.blogs.nytimes.com/2012/04/08/unemployment-and-

inflation/

The Phillips Curve for France, 1970-2013

Source: László Andor 01 October 2014;

http://voxeu.org/article/re-discovering-phillips-curve

The Phillips Curve for Germany

Source: László Andor 01 October 2014;

http://voxeu.org/article/re-discovering-

phillips-curve

Recently, questions about the PC are being asked…

• „Advanced economies have experienced little decline in inflation since the financial crisis of 2008-2009, calling into question one of the fundamental tenets of many macroeconomic theories: the Phillips curve linking the rate of change in prices to the level of economic activity”

• We nowadays observe relatively major differences in unemployment rates, while inflation remains rather low and stable.

• „The Phillips curve has not become vertical as the monetarists had predicted; it is much closer to being horizontal in recent years.” Paul Krugman

• .

Downward wage & price rigidity?

• Explanations based on recent labor market

developments, such as long-term unemployed having

smaller effects on wages, or downward wage rigidity

preventing wages from falling as much as in prior

downturns

• „It’s an interesting question why, one that has to be

answered in terms of psychology and sociology, but it’s

simply a fact that actual cuts in nominal wages happen

only rarely and under great pressure.” Paul Krugman

On the other hand….

• „Increasing evidence shows that after a flattening

occurred in the immediate aftermath of the global financial

crisis, the relationship between price inflation and

economic slack became stronger in the euro area.”

• Bulligan, Guido and Viviano, Eliana, Has the Wage Phillips Curve Changed in

the Euro Area? (September 22, 2016). Bank of Italy Occasional Paper No.

355.

Summary

We have derived the supply side of the DAD/DAS

model

• The dynamic supply curve states that inflation

depends on • expected inflation

• deviations of output from its natural level

• supply shocks

macroeconomics ii macroeconomics 2 -...

Documents